As a general rule, subject to certain exceptions, local dividends received and accrued to a South African tax resident are exempt from normal tax in terms of section 10(1)(k) of the Income Tax Act, No. 58 of 1962 (the Act). One such exception applies to employee share schemes by virtue of the application of section 10(1)(k)(i)(dd).
Section 10(1)(k)(i)(dd) of the Act
Section 10(1)(k)(i)(dd), which was introduced from 1 January 2011, prescribes that a dividend will not be exempt from normal tax if such dividend is received or accrued in respect of a restricted equity instrument (as defined in section 8C) unless:
the restricted equity instrument constitutes an ‘equity share’ for purposes of the Act, other than an equity share that would have constituted a ‘hybrid equity instrument’ as defined in section 8E(1) but for the 3-year period requirement; or
the dividend constitutes an equity instrument; or
the restricted equity instrument constitutes an interest in a trust and, where that trust holds shares, all of those shares constitute equity shares, other than equity shares that would have constituted hybrid equity instruments as defined in section 8E(1) but for the 3-year period requirement.
Accordingly, dividends in respect of restricted equity instruments (for purposes of section 8C) will be taxed as normal income in the hands of the recipient, unless it falls within one of the abovementioned exclusions. The tests to be applied in each instance are as follows:
First Test: the employee must hold an ‘equity instrument’
An ‘equity instrument’ is widely defined in section 8C to mean a share in a company, including:
an option to acquire such a share or part of a share;
any financial instrument that is convertible to a share; and
any contractual right or obligation, the value of which is determined directly or indirectly with reference to a share.
Second Test: the equity instrument must be acquired by virtue of employment
The equity instrument must be acquired by virtue of the employee’s employment. This means that there must be a direct or immediate link between the employment of the taxpayer and the acquisition of that equity instrument. The fact that there is a relationship between the employment of the taxpayer and the acquisition of the equity instrument will not be sufficient, as the employment (and services rendered to the employer) must be the direct cause for acquisition of the equity instrument. In the absence of such direct, immediate and primary cause, the test would not be fulfilled.
Third Test: the equity instrument must be restricted
An equity instrument becomes unrestricted when it ‘vests’ in a taxpayer for purposes of section 8C of the Act. An unrestricted equity instrument is deemed to vest on the date that it is acquired by the taxpayer, whilst a restricted equity instrument is deemed to vest in a taxpayer when all the restrictions in respect of such equity instrument cease to have effect, or immediately before the taxpayer disposes of such equity instrument, whichever is the earlier.
Fourth Test: the three exceptions
In order to escape a taxable dividend on a restricted equity instrument, at least one of the following three subtests must be fulfilled:
Subtest 1: In terms of this test, the restricted equity instrument must constitute an ‘equity share’, other than an equity share that would have constituted a hybrid equity instrument as defined in section 8E(1) but for the 3-year period requirement. The term ‘equity share’ is defined in the Act as a share in a company, excluding any share that, neither as respects dividends nor as respects returns of capital carries any right to participate beyond a specified amount in a distribution. The use of the words “neither as respects dividends nor as respects returns of capital” indicates that both the right to dividends and the right to the capital must be restricted before a share ceases to be an equity share. Therefore, if a shareholder’s right to dividends in respect of a share is restricted but that shareholder’s right to the capital is unrestricted, the share will still constitute an equity share (and vice versa, i.e. if the capital is restricted but there is an unlimited right to dividends). On the other hand, if the right to receive both dividends and capital is restricted, the share will not be an ‘equity share’.
The equity share must further not constitute a hybrid equity instrument but for the 3-year period requirement. In this regard, the equity share will constitute a hybrid equity instrument if:
that share does not rank pari passu as regards its participation in dividends or foreign dividends with all other ordinary shares in the capital of the relevant company or, where the ordinary shares in such company are divided into two or more classes, with the shares of at least one of such classes; or
any dividend or foreign dividend payable on such share is to be calculated directly or indirectly with reference to any specified rate of interest or the time value or money; and
any of the following three requirements are met:
the issuer of that share is obliged to redeem that share in whole or in part;
that share may at the option of the holder be redeemed in whole or in part; or
at any time on the date of issue of that share, the existence of the company issuing that share is to be terminated or is likely to be terminated upon a reasonable consideration of all the facts at the time.
Subtest 2: In terms of this test the dividend must constitute an equity instrument as defined in the first test.
Subtest 3: In terms of this test, the restricted equity instrument must constitute an interest in a trust, and where that trust holds shares, all of those shares must constitute equity shares, other than equity shares that would have constituted hybrid equity instruments as defined in section 8E(1) but for the 3-year period requirement. In this regard, the same test as in subtest 1 above will apply.
The application of section 10(1)(k)(i)(dd) can be illustrated as follows:
A trust acquires shares in an operating company. The trust then grants vested rights to the dividends received on these shares to the beneficiaries of the trust, who are all employees of an operating company, by virtue of their employment with the operating company.
The vested rights of the employees constitute equity instruments for purposes of section 8C (contractual rights, the value of which is determined with reference to the shares). If the vested rights are unrestricted, the dividends will be exempt, and if the vested rights are restricted, the dividends will only be exempt if the requirements of subtest 3 above are met.
The shares held by the trust also constitute equity instruments as a result of section 8C(5)(b). The taxation of the dividends on these shares will also depend on whether the shares are restricted or unrestricted. Assuming that the shares are restricted equity instruments, the only way to escape taxation would be if the shares are equity shares but for the 3-year period as set out in subtest 1 above.
The draft Taxation Laws Amendment Bill (TLAB) issued in July 2013 proposed to delete section 10(1)(k)(i)(dd) from the Act in its entirety in order to remove the distinction between dividends received from restricted or unrestricted employee shares. It furthermore proposed that the recipient of a dividend from an equity instrument would be taxed on the dividend as ordinary income, unless the equity instrument had vested, i.e. it applied to restricted equity instruments. The draft TLAB, however, did not state which section it proposed to replace section 10(1)(k)(i)(dd) with, as the only further section it referred to under this topic was section 11(t), as referred to in more detail below.
Interestingly, the final Taxation Laws Amendment Act, 2013 (TLAA) did not delete section 10(1)(k)(i)(dd) but, instead, left section 10(1)(k)(i)(dd) unchanged and introduced a new section 10(1)(k)(i)(ii).
According to the Explanatory Memorandum it has become apparent that the anti-avoidance rules in respect of the conversion of salary to dividends are far too narrow as they only target dividends from non-equity shares. The Explanatory Memorandum furthermore states that many employee share schemes hold pure equity shares where the sole intent of the scheme is to generate dividends for employees as compensation for past and future services rendered to an employer, without the employees acquiring ownership of the shares. The dividends received are considered by SARS to be “disguised salaries” for employees, or remuneration for services rendered in another form even though these dividends arise from equity shares.
To address the concerns raised by SARS, it became necessary to include a specific dividend exemption under section 10 of the Act, as an inclusion under para (c) of the “gross income” definition remains futile because tax exempt dividends are excluded from income in any tax calculation. In terms of section 10(1)(k)(i)(ii), with effect from 1 March 2014, a dividend shall not be exempt from tax if such dividend is received by or accrued to a person in respect of services rendered or to be rendered or in respect of or by virtue of employment or the holding of any office, other than (i) a dividend received or accrued in respect of a restricted equity instrument as defined in section 8C held by that person or (ii) in respect of a share held by that person. An analysis of section 10(1)(k)(i)(ii) reflects the following:
As a first test, the dividend must be received or accrued in respect of services rendered or by virtue of employment. It is accepted that there is no difference between the meaning of the words “in respect of” or “by virtue of”, and the distinction is rather superfluous as both require a direct or causal relationship between the employment with the company and the declaring of the dividend. Based on the Explanatory Memorandum, this requirement suggests that the dividend must be compensation for services rendered and, therefore, a disguised salary. Put differently, where dividends are received and there is no motive to disguise such dividends as remuneration, for example as a result of the shareholding only, the requirement will not be met. What is peculiar are the examples given in the Explanatory Memorandum, as they appear to have a broad stroke and suggest that any dividend received through an employment scheme will be by virtue of employment and with no regard to the motive for the declaring of the dividend.
The second test is that the dividend must not be received in respect of a restricted equity instrument, i.e. the dividend will only be taxed if it is received in respect of an unrestricted equity instrument. This requirement is quite strange, as according to the Explanatory Memorandum the dividend should not be taxed in the hands of employees where, upon vesting for section 8C purposes (i.e. when the equity instrument becomes unrestricted) the equity instrument will be taxed under section 8C. Accordingly, what the Explanatory Memorandum envisages is that if a restricted equity instrument will result in section 8C gains being taxed, a person should not be taxed on the dividend prior to such gains arising. The result of the introduction of section 10(1)(k)(i)(ii) is that no tax will be paid on dividends arising from restricted equity instruments. What is not clear is that if an employee is taxed under section 8C by virtue of the vesting of a restricted equity instrument, such instrument will in any event become an unrestricted equity instrument, with the result that the employee will pay tax on any further dividends paid on such instrument (unless it constitutes a share – see below). This requirement therefore only makes sense if one considers the first test, i.e. that dividends must be received as a disguised salary.
The TLAA further states that the measure will not apply to dividends paid in respect of a share held by the employee, i.e. direct shareholders who receive dividends in terms of employee share schemes will not be affected. It is common knowledge that all dividends are paid in respect of shares. If a taxpayer holds the share directly, the taxpayer will be exempt, which means that section 10(1)(k)(i)(ii) will only apply in an indirect environment, such as employee share trusts. This means that even if the dividend is a disguised salary, if the share is held directly it will be exempt, which seems to suggest that there is no issue with receiving a disguised salary if the taxpayer holds the share directly.
Dividends payable to natural persons are subject to Dividends Tax (DT) at the rate of 15%. Where dividends are included in the income of a taxpayer by virtue of section 10(1)(k)(i) of the Act, double taxation on the dividends may occur.
The solution suggested by the Explanatory Memorandum is that, if dividends are received and distributed in the same tax year by an employee share trust and subject to income tax in the hands of the employee-beneficiary, DT does not have to be withheld, and the trust can make a declaration to the relevant Central Securities Depository Participant (listed shares) or the distributing company (unlisted shares) not to withhold DT. Where DT has been withheld by the trust and included in the employee’s income, the trust may make the abovementioned declaration in order to receive the refund of the amount withheld and to distribute the full dividend to the employee.
Proposed dividend deductions
The draft TLAB proposed that the company declaring the taxable dividend would be entitled to an income tax deduction equal to the amount of the inclusion. In this regard, a new section 11(t) deduction was proposed. The TLAB published in October 2013 removed this proposed deduction in its entirety on the basis that it should discourage companies from “disguising salaries” to employees as dividends.
ITA: Sections 1, gross income para (c), 8C, 8E, 10(1)(k) and 11(t),